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Credit Card Blog - What do all of those credit score terms mean

 Thursday, 05 October 2006

If you’ve been browsing our site, you’ve may have noticed that some cards say they are for people with average, limited, poor, or bad credit history. These terms are a bit vague. What do they all mean? While there are some general guidelines as to what constitutes good or bad credit, every lender has their own standard, so a bit of vagueness is unavoidable.

Most people have a general idea of how their credit is. If you own your own home and have always paid your bills on time for at least the minimum amount due, and don’t use credit excessively, you likely have excellent credit. On the other hand, if you’ve had several credit cards go to collections, had your house foreclosed on and your car repossessed, your credit is probably poor. These terms “excellent”, “poor” and others correspond to a credit score.

Each of the three major credit bureaus calculates a credit score according to a secret formula, so your credit score will vary a bit from one bureau to the next. However the credit score from each is intended to measure they likelihood of default. So if your car has been repossessed for non-payment that indicates that you’re more likely to default on a loan. On the other hand, if you’ve paid all your bills on time that indicates that you’re not likely to default. The bureaus take your credit history and come up with a number that represents how likely you are to default. Low scores mean a high likelihood and high schools mean a low likelihood.

Credit scores range from the mid 300s on the low end to the mid 800s on the high end. Scores above 730 usually indicate excellent credit. 700-729 indicates good credit. 670-699 is average. 585-669 is fair. Below 585 is poor credit. These are just general guidelines. Every lender has their own standards, and those standards can vary between products.

Keep in mind that lenders don’t just look at your credit score. They may also consider how much collateral you have and your current financial status (income, debt and cash on hand). Even if you have excellent credit, you’re not likely to be approved for a mortgage if you’re unemployed and have no income.

Why do I want a good credit score?

It’s quite simple. Debt is cheaper when you have good credit. Your credit score tells the lender how risky it will be to lend to you. The higher the risk, the more interest the lender will charge you. This might seem a bit counterintuitive. You might think that the people who get higher interest rates are exactly the people who are least able to repay, and to a certain extent, this is true. However, since these people are a high risk investment, the lender wants to be paid more to offset the risk. Perhaps an analogy will help. Suppose Jane asks Bob to go get her a hamburger and that the hamburger place is just down the street and there’s little traffic. Bob, says ok, on the condition that Jane buy him a small French fries. Low risk, low payment. Now suppose that Jane wants that same burger, but that in order to get to the hamburger place, Bob has to cross a minefield and go down a street filled with snipers. Bob says ok, but now he wants payment of $250,000 plus the fries. High risk, high payment. Similarly, interest just reflects how much risk the lender is assuming. More risk equals higher interest.

E-Loan has a great FAQ about credit scores and what factors go into calculating them.

Thursday, 05 October 2006 22:34:07 (GMT Daylight Time, UTC+01:00)  #     
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